Mr Prime Minister, we like our credit cards

“The prime minister was forced to change a passage in his original speech which appeared to call on people to pay off their debts instead of spending money.”

What’s wrong with telling people to pay off their credit cards?

Nothing. Paying off your credit card is a marvellous idea. Credit cards are magnificently expensive if you start letting the balance accumulate.

Surely they’re not that bad?

It’s all about compound interest, the most powerful force in the universe, as Albert Einstein probably didn’t famously declare. Compound interest can be overhyped, usually by people trying to sell us pensions. Yet compound interest of 20 per cent a year – which some credit card companies would regard as modest – is the kind of return that puts you in the same league as Warren Buffett. You don’t really want to be offering your credit card company Buffett-style returns.

Why was David Cameron planning to offer personal finance advice?

I don’t think he intended the advice to be taken quite too literally; surely he just wanted to echo the government’s baffling mantra that it is going to pay off the nation’s credit card.

Is it?

No, it’s just slowing down the rate at which the nation’s credit card balance is increasing. In any case, the metaphor is daft, because the government is borrowing money very cheaply – about 0.5 per cent a year for a two-year loan, and 2.25 per cent for a 10-year loan.
So why did the prime minister change his speech at the last minute?

There’s a school of thought out there that suddenly having every consumer in the country close his or her wallet might not be terribly good for the economy.

Aha, this is the famous paradox of thrift?

Not quite. The paradox of thrift is the idea that when we all try to pay off our debts, in fact we end up more indebted than ever.

Huh?

It’s a more extreme version of your idea: if everyone stops spending and starts trying to save, the economy might be so damaged that incomes fall faster than spending, and borrowing increases.

Wow. Can that happen?

It’s not impossible. But it’s worth examining the idea. It seems counterintuitive and bizarre that collectively we could cause a recession by trying to be prudent with our cash. But after the idea has been explained it becomes difficult to shake it off: the cause of all economic problems suddenly seems to be pessimism and the solution is for everyone to go shopping. But there are problems with that view.

Well, yes, we can’t keep racking up ever larger debts, can we?

Not as an increasing proportion of overall income, no, we can’t. But beyond the sheer mathematical impossibility of an economy fuelled by increasing debt-gross domestic product ratios, there’s a more subtle objection. Is it really true that an economy collapses when consumer spending collapses?
Of course! What else do you expect to happen?

If prices are flexible and resources can be redeployed, then business investment should replace consumer spending. Businesses will find that it’s cheap to borrow, buy land and machinery, and cheap to hire workers – in fact, they would find that it was an excellent time to invest to take advantage of the coming boom. And the boom would come: it would be investment-led rather than consumption-led.
So everyone should pay off their credit cards?

Well, maybe a little bit, yes. The case for doing so becomes all the stronger when you consider that the UK is an open economy. In a closed economy, my spending is your salary. But in an open economy, part of my spending is Johnny Foreigner’s salary. As any politician will tell you, foreigners don’t vote.

In reality it takes time for prices to adjust and time for resources to be redeployed, so it would be a disaster if everyone tried to pay off their debts overnight. The shift from consumption to investment can’t happen instantly, so in an Augustinian spirit we must hope for the Lord to make us frugal, but not yet.

Which brings us back to the initial point: it would have been a bad idea for Mr Cameron to tell the nation to stop spending, wouldn’t it?

No, because no one listens to a word the prime minister says. But if Jonathan Ross or Simon Cowell had told us to stop shopping, that would have been a disaster.

5 Comments

S says:

“If prices are flexible and resources can be redeployed, then business investment should replace consumer spending. Businesses will find that it’s cheap to borrow, buy land and machinery, and cheap to hire workers – in fact, they would find that it was an excellent time to invest to take advantage of the coming boom. And the boom would come: it would be investment-led rather than consumption-led.”

Consumer spending accounts for 70% (incl healthcare) of GDP. Investments between 15-20%. That’s a big gap to cover. Given that most companies are swimming in cash & not spending it, it looks like wishful thinking that stopping consumption is going to be a great motivator for them to start investing (why would they if they can’t sell their products to … consumers). Even in the event that they would, given the amount of idle money put at work, chances are there will be lots of wasteful projects not producing expected returns.

I’m not too keen on the answer beginning “If prices are flexible and resources can be redeployed, then business investment should replace consumer spending.” This is the bit that misses Keynes’ central insight about investment and confidence. Why on earth would you invest in increasing production of goods you have no evidence anyone will buy? Hence the volatility of investment expenditure and hence the argument that the Government can play a role in filling in the confidence gap, hence we have a Government which knows not what it is doing… unfortunately.

George W. Bush famously told Americans to go shopping in response to the events of 9/11. He was concerned that uncertainty would lead consumers to pay off their “credit cards” and reduce their consumption. Americans listened and increased debt for 7 more years before the market collapsed. “Save more tomorrow” seems to be the defining mantra for politicians – not sure it is best for the economy.

Well, at least it got revised out of the speech. Pity noone who proofreads his speeches managed to catch the one about DNA being invented in Britain. Yep, and it was us who designed the dinosaurs as well.